Friday, December 21, 2012

Uncertainty and the demand for liquidity

In between my more practical posts, once every week or so I'll do something on the idea of moneyness. Economists have known for a long time that the concepts of uncertainty and money are intimately intertwined. George Costanza knows this too. He holds a bunch of cash to deal with all eventualities... until his wallet blows up. I'll show how we can just as easily replace money with moneyness in this two-step with uncertainty.

Uncertainty is an uncomfortable feeling one endures when thinking about an unforeseeable future. One of the ways to shield oneself from uncertainty is to devote a certain portion of one's portfolio to "money" – dollar bills, bank deposits, and such. Because these money items are liquid, it will be relatively easy for their holder to offload them in the future should some unanticipated eventuality arise. Holding money therefore alleviates discomfort about the future. This is the same sort of service that a fire extinguisher provides. Though someone may never need their extinguisher, it comforts its owner by its mere presence. On the margin, individuals are always comparing the present value of the stream of "security and comfort" that money provides to the consumption goods or durable assets that money can buy.

The link between uncertainty and the demand for money has a long heritage. We can find this idea early on in the Marshallian tradition, for instance. In 1917 Arthur Pigou, a student of Marshall, wrote that any person would be anxious to hold money "to secure him against unexpected demands, due to a sudden need, or to a rise in the price of something that he cannot easily dispense with." On the margin, people could either hold money, spend it on consumption, or exchange it for a capital asset. "These three uses," wrote Pigou, "the production of convenience and security, the production of commodities, and direct consumption, are rival to one another." (The Value of Money, 1917)

In 1921, Fred Lavington explicitly described this very same link between uncertainty and money.

the stock of money held by a business man serves not only to effect his current payments but also as a first line of defence against the uncertain events of the future. (The English Capital Market, 1921)

More explicitly, said Lavington, money provides its owner with a

return of convenience and security. His stock [of money] yields him an income of convenience, for it reduces the cost and trouble of effecting his current payments ; and it yields him an income of security, for it reduces his risks of not being able readily to make payments arising from contingencies which he cannot fully foresee. The investment of resources in the form of a stock of money which facilitates the making of payments is then in no way peculiar; it corresponds to the investment by a merchant in the office furniture which facilitates the dispatch of business, to the investment of the farmer in agricultural implements which facilitate the cultivation of his land, and indeed to investment generally.

Like Pigou, Lavington emphasized the marginal choice between holding money, spending it on consumption, and investing it.

Resources devoted to consumption supply an income of immediate satisfaction; those held as a stock of currency yield a return of convenience and security; those devoted to investment in the narrower sense of the term yield a return in the form of interest. In so far therefore as his judgment gives effect to his self-interest, the quantity of resources which he holds in the form of money will be such that the unit of resources which is just and only just worth while holding in this form yields him a return of convenience and security equal to the yield of satisfaction derived from the marginal unit spent on consumables, and equal also to the net rate of interest.

The most famous adopter of this idea was Keynes, a friend of Pigou's and, oddly enough, Lavington's teacher.

Because, partly on reasonable and partly on instinctive grounds, our desire to hold Money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future... The possession of actual money lulls our disquietude; and the premium which we require to make us part with money is the measure of the degree of our disquietude. (The General Theory of Unemployment, 1937)

The link between uncertainty and money isn't confined to the Marshallian and Keynesian traditions. Erich Streisler (1973) quotes Carl Menger in Geld:

The amount of money which is used in actual payments constitutes only a part, and indeed a relatively small part, of the cash necessary to a people, and . . . another part is held (in order that the economy may function without friction) in the form of various reserves as a security against uncertain payments, which in many cases in fact are never realized.

William Hutt, an Austrian "fellow traveler", described the prospective yield from money in a 1952 paper called the Yield from Money Held. According to Hutt, the value of money assets was "affected by reason of their being demanded for their 'liquidity,' i.e. for the medium of exchange services that they can perform." These monetary services that money assets provide are prospective
–
even though money isn't being used, much like a fire engine when there were no fires, it isn't lying idle. "The essence of all these services is availability," wrote Hutt.

Modern Austrian Hans Herman Hoppe provides a very sharp linkage between uncertainty and money holdings.

the investment in money balances must be conceived of as an investment in certainty or an investment in the reduction of subjectively felt uneasiness about uncertainty. ('The Yield from Money Held' Reconsidered, 2009)

Nor is the Auburn side of the Austrian school the only to note linkage. Steve Horwitz, a free-banking Austrian, also gives expression to the link between money and uncertainty:

The connection between Hutt and Menger lies in recognizing that the availability services that money provides flow from it being the most saleable good. To be available to be exchanged for anything at any time requires that the good have the degree of saleability that Menger describes. The nature of Hutt's availability services is that they are a subjective return to holding an item that others also subjectively value a great deal, thus permitting the item to be easily exchangeable. When one chooses to hold wealth in the form of money, one is simply purchasing these availability services. (A Subjectvist Approach to the Demand for Money, 1990)

We also find the link between uncertainty and money among monetarists. In their 1971 paper The Uses of Money, Brunner and Meltzer noted that in a world of perfect certainty, information is available for free. This effectively eliminates the main reasons for the existence of money. However, by relaxing the assumption of certainty, “transactors possess very incomplete information about the location and identity of other transactors, about the quality of the goods offered or demanded, or about the range of prices at which exchanges can be made.” Rather, they must acquire information about these characteristics. Because knowledge acquisition takes time and energy, individuals may alternatively:

search for those sequences of transactions, called transaction chains, that minimize the cost of acquiring information and transacting. The use of assets with peculiar technical properties and low marginal cost of acquiring information reduces these costs. Money is such an asset.

David Laidler, also a monetarist, describes the money as a "buffer against costly consequences of market uncertainty and inflexibility".

If money holding is a cheap and reliable buffer, then agents will find that it pays to remain relatively uninformed about the processes affecting the variability of their net receipts, and will be relativley unwilling to undertake any costly measures that might render them either more predictable or controllable. If, on the other hand, money holding itself is a costly or unreliable source of insulation from such uncertainty, then the expenditure necessary to acquire and utilise extra information is more likely to be made. (Taking Money Seriously, 1990)

It's clear from this wide variety of quotes that many economists have considered money holdings to be uncertainty-alleviating. It's not a big step to replace the concept of "money" with "moneyness". The idea here is that by selling less-liquid items for more-liquid items, individuals can increase their protection from uncertainty. All assets can be ranked on a scale according to their liquidity/moneyness, and as a corollary, by their ability to "lull our disquietude".

On the margin, people are constantly comparing the package of services provided by each asset in an economy, where each package consists of the real services the asset provides, its pecuniary returns (interest, capital gains, or dividends), and finally the extent to which that asset's moneyness shields the holder from uncertainty. This means that in trying to defray their worries about a cloudy future, people seek out the quality of moneyness rather than a specific instrument called money. This quality, or property, is never fully concentrated in one hypothetical asset called "money" but can be found unevenly distributed over the economy's entire range of goods.

10 comments:

I'm not sure if this is a disagreement, but I think there's something important involved that you don't explicitly consider. "Moneyness" also has to do with transaction costs; the more liquid a good, the cheaper it is to engage in exchange (for a variety of reasons). This liquidity is what makes money valuable as a means of preparing for uncertain near future expenditures. I see how "moneyness" is directly relevant, but I feel like the quality of moneyness is what induces people to hold the particular asset, as opposed to the demand for money instilling "moneyness."

I'm not sure if you were implying what I suggest in the last sentence above. Also, I'm sure that I'm leaving something out: call this an attempt to clarify my understanding.

you know why some people is rich(new) and some is not rich (about one busnieses )or company or GV ...WE say this man/women (is ciguna)or (spataly) everyone have grow with neotropies..RICH PEOPLE DOESN'T SPEND WITH OUT REASON .....they make 100 calculation and spend 1 ..so MONEY IS TOOLS TO EVERYONE (LEGO) and this is up to everyone how to use or play ..MIDDLE CLASS have 40% people who don't know to use money IN THE END they are all failure..they take from bank's a now can not pain .why because this generation Middle class dont'come from rich class allmost come from middle or poor class AND THEY DON'T KNOW TO PLAY WITH MONEY.just like to show lif&styl (with out are)..with others money this is the basic of the bank problem liberation (they wanted more proffit) but some time when we want to much ..we lose the les..I have one propose for the people don;t know to use money (PLAY MONOMPOLY)..play LEGO...or play chess..IF THE DON'T KNOW DONT MAKE ANYBUSINESS .OR DONT MAKE SACRIFICE THE LIFE FOR OTHERS..MONEY IS GAME THANK YOU

Liquidity demand could potentially matter for gold, silver, tobacco, etc., but when we start talking about the liquidity demand for paper dollars, checking account dollars, credit card dollars, etc, we are in a whole different ballgame. Those things can be created costlessly and instantly in infinite quantities, and they are the liability of their issuer.

Mike, in this post I avoided talking about the implications of the demand for liquidity on prices, but in future posts I'll try and get into this.

My rough and uncensored thinking on this is that an individual's equity, or net worth, is rendered more liquid when it can be securitized and traded. If it is difficult to trade away one's equity, then that equity will be worth less. Any addition to the liquidity of one's equity increases the market price of one's equity.

Hi LK, good post. There might be place for a regression theorem (or something like it) to explain why a new fiat object might ever earn "direct utility" as a money. Have you read Selgin's "The Yield on Money Held Revisited: Lessons for Today"? He makes use of the regression theorem in this sense.

I don't see how this has anything to do with the regression theorem. The regression theorem explains how a non-money good had value before it began taking on moneyness value.

How does an additional direct utility gained as the good takes on more moneyness - holding cash balances as a way of dealing with future uncertainty, which all Austrians emphatically stress - have anything to do with the validity of the regression theorem? Which, again, merely shows that before the good had any moneyness its value was derived from its direct consumption use as a fish hook, in the case of Lari money. Or as a cigarette, in the case of a prison economy. Or as jewelery, in the case of gold/silver. And so on.

"The regression theorem explains how a non-money good had value before it began taking on moneyness value... merely shows that before the good had any moneyness its value was derived from its direct consumption use as a fish hook"

Good comment. What you are describing is more like Menger's theory about how an item first has use value and only then gets exchange value. Mises's regression theorem is a very specific attempt to attribute to fiat money yesterday's utility, and yesterday's utility to the day before's, etc etc, until we arrive at the day on which fiat money was gold linked. It's a very specific story about backwards expectations.

I'm a big fan of Menger, not so much Mises.

From a moneyness perspective, an item takes on moneyness based on the holder's forward looking expectations about the prospects for that item's future sale. These prospects are based on the expectation that someone else will value that item for its direct utility and that therefore a market will emerge for it. So direct consumption (or at least the possibility of it) comes prior to moneyness, which is what Menger said. Menger didn't explicitly state the idea of marketability/moneyness as expected future marketability/moneyness.